The Truth About Deficit Spending

It's tempting to place partisan blame on why the U.S. has such persistent federal deficits, which results in a large amount of federal debt. Some say it's the Bush era tax cuts, while others blame Obama. But the problem with deficit spending really began around 1970. It's not a new phenomenon, and deficits have persisted during good economic times, as well as bad.

A big issue is that our budget deficits during recent decades have been caused primarily by health care costs and an aging population. In fact, research from the St. Louis Fed demonstrates that Medicare spending, and to a lesser extent, Medicaid, are the primary culprits in creating our deficits. And we can see that raising the highest marginal rates on high-income earners might not solve the issue. Let's explore.

The financial crisis merely brought forward what likely would have been a problem, anyway. We were already on track to have large deficits even without the crisis had we continued on the same path as in previous decades. It's just that those problems would have begun a few years later.

Here's the problem: Mandatory spending for Medicaid and Medicare increased to 31% of the budget in 2011 from about 18% in 1979. As a percentage of GDP, this category of spending increased to more than 8% currently from less than 4% in 1970. What do we mean by mandatory? Payments that are decreed by law and not an annual budget process. We determine in an ongoing legislative process how much to spend on programs like highways, education or defense, but spending on interest on the federal debt, Social Security and Medicare are automatic. That spending doesn't change easily.

Spending on defense has declined consistently with the end of the Cold War, aside from the current wars. Spending on discretionary programs has remained relatively stable over the past few decades. The discretionary programs that are subject to the annual budgetary process are actually rather small. There's not a lot of room to cut these programs. Trying to squeeze blood out of this turnip won't fix our problems.

Fixing the deficit might not come from taxing the rich more, either. Research demonstrates little correlation between higher tax rates and the average tax revenues. Average tax revenues prior to the recession have been rather stable, despite big decreases or increases in marginal rates. While the Bush tax cuts do appear to have reduced tax revenues in the early 2000s, tax revenues had rebounded as the economy improved following the recession of the early 2000s. (You may recall that that recession, in part, had prompted the tax cuts to begin with.)

Raising tax rates doesn't seem to influence the average or total tax revenues. As tax rates go up, people have more incentivize to look for loopholes -- things like deductions and tax credits. This can prevent tax revenues from rising when tax rates increase. Instead, the research suggests that closing these loopholes would likely increase tax revenues, which may help reduce the deficit. While the average tax rates are already progressive, the researchers note, closing deductions would raise tax revenues more on higher income (and yes, some middle class) taxpayers more than on lower-income citizens.

But the issue isn't so much on the revenue side of things, aside from the recent drop in revenues because of the financial crisis. The issue is government spending. On average, the government spent 2.4% of GDP more than it received in revenue from 1970 to 2007. Thus, most of the increase in the debt over the entire 1970-2007 period occurred because the government spent about $6 trillion more than it collected in taxes over the entire period.

So it's not a recent phenomenon, and neither party is entirely to blame. What it comes down to, though, is that our rapidly increasing health care costs and an aging population are behind much of the increase in our spending, not discretionary programs that can be resolved with budgetary fixes. Finding a way to resolve the escalation in entitlement spending, particularly Medicare, is essential to fixing our deficits. If we can't find an effective way to control these costs, we will need to think long and hard on how to increase revenues to pay for them.